Back to Basics in Biotech – TheStreet.com

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(This commentary originally appeared on Friday on Real Money Pro. Click here to learn about this dynamic market information service for active traders.)

The market’s volatility has picked up in recent sessions on geopolitical concerns around North Korea. Equities were overdue for a breather anyway; they have enjoyed extremely low volatility levels throughout 2017 as the market has slowly marched forward throughout the year.

High beta sectors like small-caps and biotech stocks have been hit particularly hard. The number of questions I am fielding on small biotech stocks I have profiled and own has escalated sharply this week. Given this, I think it is a good time to bring back a primer on some core tenets I have found work well in my quarter century investing in this highly volatile part of the market.

Risk Profile and Diversification:

An investor should know his risk profile before choosing to invest in the small biotech space. If one is bothered by 5% daily moves just because sentiment shifted on the sector, it is probably a space to be avoided. Even if one’s risk tolerance is high, at least one half of your biotech holdings should be in large-cap names like Celgene (CELG) . This will take a lot of volatility out of your portfolio and make the frequent “hiccups” in this space easier to deal with.

Stop losses do not work in this part of the market. If a trial goes awry, a stock can gap down 50%, 60% or 75% in an instant. The only thing that stop loss 20% below current trading levels is providing is a false sense of security. Small stakes in myriad promising small-cap names across numerous disease areas providing proper diversification is the only effective risk management tool.

Avoiding IPOs:

Unless you are golfing buddies with a big-name broker that can get you some shares in a hot, much anticipated IPO at the offering price, this is a space best left alone. Wait 18 months and come back to that stock you originally wanted on its debut. It is highly likely you will find it is a “Busted IPO” now and can be had for 30 to 50 cents on the dollar to the where it became public, now that analyst hyperbole has faded and lockups have expired. Usually, the company is farther down its development path, as well.

Don’t Chase Individual Rallies:

This is a space where good news can buoy shares as much as bad news can implode them. It is tempting to chase a stock that has doubled due to positive trial news, a positive FDA decision or announcement of large collaboration deal with a major drug giant and seems to have the “Big Mo”. My advice is to wait a bit.

A lot of times, that big one-day rally that took the stock up 80% on positive news had a substantial element of short covering. In addition, many times a small developmental firm will soon announce a significant capital raise via a secondary offering, providing another opportunity to grab shares at a lower price.

Fibrogen (FGEN) provided a great example of this sort of price action this week. Shares rocketed from the low $30s to more than $50 on Tuesday, on the back of positive mid-stage trial results and a couple of analyst upgrades. Those same shares can be had for just over $40 a share two days later.

Those are just a few quick tips to navigate this high beta space when volatility spikes.